Western Investors Are Riding the Tiger in Booming
China

W hat's a China investor to do? The macro indicators for the world's most populous nation are the best they've been in more than a decade. Growth is up (projected 8% for 2000), exports are strong, deflation is easing and a raft of serious financial-market reforms are being aggressively rolled out with the blessings of the highest Chinese government officials.

The Internet, telecom equipment, and other high-tech sectors in China are taking off like gangbusters, too. The number of Chinese Web surfers, which has doubled every six months for the past two years, now stands at 16.9 million and rising. There are presently 50 million mobile-phone subscribers in China, a number that's on track to triple within three years. And new wireless-device makers, ISPs, broadband suppliers and data-storage companies are sprouting every day like mushrooms after a spring rain.

So, what's the problem? Only this: Western investors still have an extremely limited menu of choices allowing them to ride the Chinese tiger's tail. The Chinese share market is still highly fragmented, opaque by Western standards and, at least in that portion open to foreigners, tiny and illiquid. Take the two classes of Chinese stocks: A shares, open only to Chinese investors, and B shares, for foreigners. Both shares sell in China's two main equity markets, in Shanghai and Shenzhen. There are more than 1,000 A shares in a market capitalized at more than $520 billion, while the B-share market boasts just 111 stocks with a total market cap of about $6 billion.

But things are changing, and fast. China's entry into the World Trade Organization, which Beijing bought with a breathtaking array of promises to open markets to foreign competition, is virtually certain to occur within the next six months. On Tuesday, the U.S. Senate is expected to vote to normalize trade relations with China permanently. A raft of new issues from China's biggest and ostensibly best companies -- including Air China and oil companies
Sinopec
and
CNOOC
-- are in the pipeline. Most important, Beijing has announced it will consolidate the country's fractured equity markets -- A shares and B shares in Shanghai and Shenzhen -- into one market in Shanghai.

"It's a totally unique opportunity," said William Valentine, president of Valentine Ventures, an investment-management firm specializing in global stocks and bonds. "China's made huge progress trying to make their markets closer to the rules Western investors play by. Compared to the last 20 years, there's never been a time when the country's leaders have had a greater interest in seeing it happen."

Fund managers like Valentine are already combing through stacks of data on A shares closely so that when the two markets merge, they can start buying on Day One. Lists of A-share companies are easily accessible on the Internet, such as at CBSMarketwatch.com, and in recent years A shares have begun to offer surprisingly detailed financial reports to financial data vendors such as Dow Jones, Reuters and Bloomberg.

David H. Smith, the managing director of Grayling Management, an Asian market-research house and hedge fund, is also giving A shares close scrutiny these days. One of his favorites is
Shenyang Neu Alpine Software
, a software manufacturer with sales of 28 million remnimbi ($3.4 million) in 1994 and R727 million last year.

Not only that, the company, like more than a few of China's A shares, achieved last year what Western conventional wisdom deemed impossible for a Chinese company: profitability, reporting operating earnings of R138 million.

"The real interest in China should be on the unification of the A- and B-share markets," Smith says. After that happens, "the comparison of a company like Shenyang Neu Alpine Software won't be to Huasheng Cement; it will be to
Cisco
and
Oracle
."

Anticipation of the A- and B-share merger this year has powered a spectacular rally in the B shares, a perennial dog of a market (up only 12% since 1995), which have gained 80% in Shanghai since the beginning of the year. The rally has been mostly fed by Hong Kong- and China-based speculators, however, with savvy foreign investors waiting for the better capitalized and better managed A-share companies to come on the market.

Meanwhile, opinion is sharply divided over virtually all other Chinese equities available to foreign investors.

Pure China Internet stocks are the best case in point. Closely tracking the fortunes of American Internet darlings like
Amazon.com
,
Yahoo,
and
America Online
, Chinese Internet companies had a glorious run right up until April's global tech wreck.
Chinadotcom
, the first Chinese-language portal site to make it to the Nasdaq, raised $84 million in its July 1999 IPO and $395 million in a secondary offering last January.
Sina.com
, which according to some surveys is China's most popular Website, got $68 million in a hair-raising IPO last April 13, only a day before the tech meltdown on the 14th. Its IPO price was 17 and it last traded at 21.

Nowadays, every China portal but Sina is trading far below its IPO price. Chinadotcom, which launched at 20 and recorded a high of 78, last week traded at 16.50;
Sohu
, launched at 13, fetched 7.75; and
Netease
, with an IPO price of 15.50, last traded at 6.50.

"People are suspect of the advertising model," said Sanjit Devgan, chief equity analyst for Prudential Securities in Hong Kong. The most optimistic projections for the total online ad market in China is around $400 million a year by 2004, Devgan said, while the projections made by the leading portals are two to three times that figure.

Private foreign investors, meanwhile, are by all accounts still pouring into China, focusing not on yesteryear's sexy Internet portals but rather on a somewhat more mundane but potentially lucrative lineup of equipment manufacturing, business-to-business services and infrastructure projects such as server farms, networking, data storage and the like.

"We are still extremely interested in China," said Andreas Seavropoulos, a director at the Silicon Valley venture-capital firm Draper Fisher Jurvetson. The company was the lead investor in eTang, which raised more than $45 million from a consortium of Silicon Valley firms in early 2000. The company's vague business model -- to spend vast sums on advertising to establish the "eTang" brand for clothes, watches, and other goods -- has left it floundering. These days, Seavropoulos says, DFJ's venture projects are focusing more on "tactical and short-term strategies that will get the companies to hit specific milestones" in market share, sales and earnings.

The most attractive China stock to most foreign investors at present is
China Mobile
, the state-run company that holds 82% of the country's mobile telephone market. With China having recently passed Japan as the world's largest mobile-phone market with 52 million subscribers, and with China Mobile announcing capital expenditures of $10 billion over the next two years, investors are smelling a rich sinecure in the company's shares. That expectation has made China Mobile the second-most valuable company traded on the Hong Kong Stock Exchange, with a market cap of $108 billion, exceeded only by venerable
HSBC's
$125 billion.

But skeptics of China Mobile and of its scrappy competitor
China Unicom
have had the upper hand with both of these shares recently. Now trading at 36, China Mobile is down 25% over the past three months; China Unicom, trading recently at 28, is down 17% in the same period. One reason is the April tech wreck. Another is that the traditional worries about China's "Red Chips" are for the moment ascendant over greed. Foreign investors' experiences in China over the past decade have been rife with roller-coaster rides of prom- ised riches followed by crushing disappointments.

Ironically, China Mobile and China Unicom shares these days are being pressured by the same forces that are stoking foreign investment interest -- China's anticipated joining of the WTO. To gain entry, China promised to allow foreign telecom companies to compete against its established monopolies, as well as to lower tariffs that heretofore have offered domestic companies comfy protection.

For these reasons, Devgan of Prudential sees China Mobile and China Unicom as investments suitable only for those with one-to-two-year horizons -- which is actually a mere flicker to diehard devotees of China's speed-of-light entrance into the modern world that has been unfolding over the past 20 years.

"Does it really make sense that a country of genius, a country of size, and a country of great resources isn't going to have any decent equity opportunity?" asks devotee David H. Smith. "Does it make sense that A-shares are going up every once in a while because the Chinese people aren't smart, aren't financially savvy, and are subject to periodic bouts of lunacy?" He leaves the question dangling as he gazes on his computer screen at some fabulous A-share he recently discovered.

DOUGLAS C. McGILL, former editor-in-chief of Virtualchina.com and Hong Kong bureau chief of Bloomberg Business News, is a Chicago-based writer.

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